Why is the US printing more dollars?

MUMBAI: I used to think candle-lit dinners were romantic, until I became a part of one. There we were, sitting across the table with two candles between us, looking at each other. But soon enough, mosquitoes started their sting-song, sending me scurrying across the room to switch the lights back on.

“I have been reading,” she said. “And the more I read, the more confused I get.”
“There goes our romantic evening,” I told myself.

“The Federal Funds Rate, the rate at which the US Federal Reserve lends to banks in the country, is currently at 1%. Despite this, the interest rate charged on a 30-year home loan in the US is still at 5.5%. Why is there such a huge gap?” she asked.

“The primary reason is that banks do not want to lend. They find lending to small borrowers very risky at this point of time, which is kind of ironical, given that until around a year back, they were falling over one another to lend money. Hence, even though the Federal Funds Rate is at 1%, banks continue to lend at a much higher rate.”

“But is that the only reason? What happened to the $350 billion of the $700 billion troubled asset relief programme (TARP) the US government has used to recapitalise banks? Wasn’t that supposed to jumpstart lending?”

“Technically, yes, the bailout money was supposed to help the banks and financial institutions in the US so they could start lending again. But this is not what the money has been used for. Experts suggest that nearly a third of the $350 billion already spent has been used by banks to pay dividends to their shareholders. Of the remaining, some amount of money has been used to pay salaries and bonuses to employees of these banks and financial institutions. Some banks have deposited the money back with the US Fed or used it to buy financial securities issued by the US government,” I explained.
“So, the money given under TARP came with very few terms and conditions, giving banks the leeway to use it the way they want?”

“You are right, but it doesn’t stop there. News just coming in seems to suggest that banks have been using this money to even make acquisitions. Bank of America, which is getting $15 billion under TARP, is using the money to double its stake in the China Construction Bank, which happens to be China’s second-largest bank. After the deal is finalised, the Bank of America will hold 20% stake worth $24 billion in the bank.

Similarly, US Bancorp, which got $6.6 billion under TARP, is using the money to buy out two lenders — Downey Savings & Loan Association and PFF Bank & Trust. Both these lenders are based out of California (“TARP Funds Fueling Global Buyouts, Not Lending” by William Patalon III, December 5, 2008, www.seekingalpha.com),” I explained.

“How convenient? If they had to raise the same amount of money through the market, they would have had to pay a very high rate of interest, i.e. of course only if some investors were ready to lend them the money.”

“But there are other reasons for banks not lending. The collapse of the structured investment vehicles (SIVs) is also a reason banks have slowed down their lending. You know by now that most banks and financial institutions giving out home loans and other loans did not keep home loans on their books. They used to securitise these loans by converting them into financial securities — called mortgage-based securities (MBS) — and selling them to investors. This ensured that they immediately got back a large portion of the money they had given out as a loan, thus cutting out the risk and freeing up capital for lending again. The investors, on the other hand were passed on the major portion of the equated monthly instalments (EMIs) that the borrowers repaid. SIVs were big investors in these MBS and other asset backed securities (ABS). At one point of time, they had around $400 billion invested in these securities.”

“And then?” she interrupted.

“The way these SIVs operated was ‘borrow short, lend long’. In other words, they essentially issued commercial paper, which was bought by other investors, but which matured in less than one year, and used the money thus raised to buy MBS and ABS. But at least MBS were clearly long term, with maturity periods of as long as 30 years. So the entire business worked till SIVs could keep issuing commercial paper. Then the news started to come in that a lot of MBS held by the SIVs was going bad, in that those who had taken home loans backing the MBS were not paying up their EMIs.

So the SIVs were not getting paid against the MBS they had bought. This, in turn, led to investors not wanting to put money in commercial paper issued by SIVs. And this led to the entire securitisation market coming to a stand still. Also, since SIVs could not issue any commercial paper, they had to sell the MBS they had previously bought in order to repay the commercial paper that matured and had to be repaid. But since the MBS held by these SIVs had supposedly gone bad, there were no takers for these. And this led to a whole lot of SIVs going bust. A lot of big banks such as Citigroup and Dresdner Bank of Germany had set up SIVs to play this business,” I explained.

“And since there are no SIVs now. There is no securitisation market. Since there is no securitisation market, banks cannot securitise the loans they have given. And since they cannot securitise these loans, they obviously cannot keep lending at the same frantic pace as they had done before and more than that they continue to carry the risk of the loan going bad on their books. And given the increased perception of risk, they are charging a higher rate of interest on their loans even though the Federal Funds rate is at 1%. The situation I guess is more or less the same in the United Kingdom and other parts of Western Europe as well,” she said with a lot of enthusiasm. “But how are governments and central banks planning to tackle this?” she asked.

“Well, governments and central banks all over the developed world are now trying to flood the markets with money. The US Fed has announced another plan to spend a whopping $800 billion to buy MBS and ABS. It also plans to buy US government financial securities held by banks and other financial institutions, to flood the financial system with more and more money. This they are hoping will lead to banks getting into the lending mode again.

Other than this, there are plans of a fiscal stimulus of anywhere between $500 billion and $700 billion being legislated as and when Barack Obama takes over as President of the US. This money will be used primarily on infrastructure projects, social reforms, etc. The idea is to flood the economy with money so that banks lend, people earn more and then they go out and spend that money, which in turn revives consumption and that in turn revives the overall economy. At least that’s the theoretical construct.”

“But where is all the money going to come from?”
“Oh, that’s simple. They are simply going to print it. Quantitative easing is what economists have been calling it.”
“But isn’t that abusing the strength of the US dollar?”

“Yes it is. But right now dollar is a very strong currency. And everybody wants to hold it even more after the financial crisis. And that explains the fact that even though the US government is borrowing more US dollars, the interest rate they are paying on their borrowing continues to be very low. But if they continue to abuse the strength of the dollar by printing more and more of it, as they are doing right now, who knows what might happen.”

“Are you suggesting the US dollar could be the next big bubble to burst?”
(The example is hypothetical)
References: ‘Central Bankers Open the Floodgates to Flight Deflation’ by Gary Dorsch, December 3, 2008, www.safehaven.com; ‘Plan C’, Economist, November 29-December 5, 2008.